Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Fiscal policy: Spending or taxing more

Fiscal policy refers to any changes in government spending or

taxation. Unlike monetary policy, fiscal policy isn’t usually delegated to some independent authority, such as the central bank. Instead, politicians decide it and civil servants implement it ‘in-house’.

Like monetary policy, fiscal policy can have a large impact on the economy (at least in the short run), and it also comes in two sweet or bitter flavours:

Expansionary fiscal policy: Involves increasing government spending, reducing taxation or both. It’s designed to stimulate the economy and in the short run is likely to lead to higher output but also higher inflation.


Contractionary fiscal policy: Involves decreasing government spending, increasing taxation or both. It’s designed to slow down the economy and in the short run is likely to lead to lower output but also lower inflation.

We discuss fiscal policy at length in Chapter 11.

Playing policy games

Both fiscal and monetary policy have the potential to be misused by politicians acting in their own self-interest.

For example, stimulating the economy shortly before an election in order to reduce unemployment and increase output is perfectly possible (perish the thought). In the long run, however, output and unemployment return to their original levels – only inflation is permanently higher. The government may even need to engineer a recession to get inflation back down again after the election, leading to boom and bust (a period of rising prosperity and falling unemployment followed by a sharp fall in living standards and a rise in unemployment).

For this reason, economists have been arguing for some time that policy makers need to be constrained in some way by rules, so they can’t just use their discretion to game the system to their advantage. In the past few decades, macroeconomists have been winning the debate. In many countries, monetary policy is now operationally independent of government: that is, central banks are allowed to operate with little government interference. This change has led to a period of low and stable inflation in those countries.

Similar proposals have been made for fiscal policy, for example, requiring that the government balances its books on average. This change, however, hasn’t happened. Most governments are quite happy to run persistent deficits,

which future generations will have to pay back.

We discuss strategic policy makers and the rules versus discretion debate in detail in Chapters 12 and 13.